Basics of Equity Compensation
Equity compensation is a way for an employer to increase their benefits package to attract talent in the workforce. This is a growing portion of individuals’ net worth as a recent Schwab survey stated that equity compensation makes up, on average, 32% of employees’ net worth. There are many different types of equity compensation and it’s important to understand the differences between them. While this is not meant to be an inclusive analysis, it should provide a base line knowledge of equity compensation.
Stock options are granted to employees to provide them the opportunity to purchase stock in the company at a pre-determined price, which is often referred to as the grantprice or exercise price. The hope for the employee is that they can exercise their option to purchase below market price – buying the stock “on sale.” The difference between the price paid and the market price is what we call the bargain element. The type of stock option you have been granted and the length of time you hold the exercised position before selling will determine the taxation of this bargain element.
Employers want to incentivize employees to have long tenures with their firm. One way to do that is through a vesting schedule, which delays the number of options you can exercise over time (we often see vesting schedules with profit sharing and 401(k) employer matching, as well). There are several different types of vesting schedules, and you can find these on your Grant Agreement.
As mentioned above, being awarded stock options gives an employee the opportunity to purchase. This means that the employee may have stock options but never exercise them to purchase any shares, whether it’s due to a lack of capital, a lack of interest in owning the stock, or perhaps, because their options remain “underwater.” This means the exercise price exceeds the market price – and would require overpaying for the shares! Stock options can expire unexercised and there is no tax implication when this happens. It’s also important for each employee to know what happens if they are terminated or leave the company where they had vested stock options. Each company mandates this a little differently.
Additionally, it is important to cover the taxation component when discussing stock options. The type of stock option you have determines the varying points of taxation and whether tax will be withheld by your employer, or if you will need to coordinate with your Financial Advisor and CPA to ensure the tax is paid. When evaluating the taxation of your stock options, the following dates may come into play: grant, vesting, exercise, and sale.
Equity compensation may be part of your benefits package as an employee. It’s important to understand it so you can take advantage of what’s offered to you. Our team is equipped to help you think through these potentially lucrative offerings and guide you through how this type of compensation can help you reach your financial goals.
Listen to our podcast on The Basics of Equity Compensation here
Brooke Cassady
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